Potential in the Panic

Thursday, April 19th, 2018

For those looking to diversify their portfolio, hybrids have historically provided an area worth investigating. The recent sell-off in Tier-1 Capital Notes (AT1) has presented an opportunity for investors with a medium to high risk tolerance and appropriate investment time horizon. These securities are traded on the ASX and the yield is typically a factor of the coupon rate + the 90 BBSW * (1-Corporate tax rate).

These AT1 securities are issued by banks and the margin at which they are issued is based on prevailing market conditions and the size of the issuance. For example, Westpac have offered four capital notes since 2014, including WBCPE BBSW+3.05%, WBCPF BBSW +4.00%, WBCPG BBSW +4.90% & the most recent WBCPH BBSW+3.20%. All other major, regional and smaller banks also issue these capital notes. Each pay distributions quarterly. Like its peers, the newly-listed WBCPH comprises equity and debt attributes – it is unsecured, perpetual, convertible and subordinated. We believe these securities are not a substitute for fixed-interest securities or term deposits and should instead complement a broader diversified portfolio.

The sustained sell-off in the banks’ Capital Notes stems from a coagulation of downward pressures. Initially it was a greater supply of Bank-issued T1 Capital notes, whereby investors tend to switch from existing AT1 capital notes to participate in these new issuances. Notably, the fear generated from the Banking Royal Commission & Labor’s proposed cut to the franking refunds have added to investor concerns and hence this downward pressure. Since these announcements, investors have been selling notes to prices where we believe we can find value. Though ground, we see the selling as appearing to be overdone.

At the time of writing, we are on the eve of Turnbull’s 30th consecutive news poll defeat, a Labor victory in the next Federal election seems all but certain. The legislation will also have to navigate through the senate to arrive in time for July 1, 2019. While potentially limiting the application of franking, importantly the proposed policy change does not destroy it. Furthermore, according to a recent Morningstar report, only up to 20% of the AT1 investors would be impacted by this proposed change.

The Royal Commission has also contributed to weakness in the headline banks’ stock and has reverberated through to their respective capital notes. This has been exaggerated with the Basel III mandates, which require a more onerous capital ratio mandate and as such, the notes will begin to take on incrementally more equity-like attributes. This fall in market price has increased potential yield.

Over recent months, the 90-day bank bill rate has gone up by around 20bp. We see this as being positive for these notes due to the dividend payment being reset every 3 months based on prevailing bank bill rates.

For those with a higher risk tolerance and appropriate investment time horizon, Tier-1 Capital notes such as WBCPH may be worth investigating.

The Clime Group holds various ATI capital notes across its income mandates, including WBCPE & WBCPG. 

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